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Europe's giant food retailers have accumulated massive buyer power, forcing strategic change right through the supply chain.
Tony McAuley, CFO Europe Magazine
August 23, 2004
In late 2001, Levi Strauss & Company, custodian of one of the world's most iconic brands, won a landmark case in the European Court of Justice to force Britain's dominant food retailer, Tesco, to stop selling its 501 brand of jeans at £30, well below Levi's £45 recommended retail price. The decision was hailed by "brand owners" as a victory in their battle to protect expensive franchises against the increasingly powerful and aggressive mega-retailers. However, by April 2004, and with the manufacturer's full support, Levi's new "Signature" brand jeans began appearing in a dozen Tesco stores in Britain, priced at just £25 (€37) a pair. Levi's may have won the legal battle, but Tesco—and other big retailers—have won the wider marketing war.
While the move by $4 billion (€3.3 billion) Levi Strauss to sell a cheaper range was seen by many as inevitable (indeed, belated), it also demonstrated vividly a power shift that has occurred over the last few years, particularly in Europe. The giant food retailers have, to a large extent, turned the tables on the brand owners, controlling customer information through new technology, developing their stores as strong brands in their own right, dictating price terms to suppliers and forcing profound strategic changes right through the supply chain. What's more, with relentless downward pressure on prices in Europe's largest industry, it is the finance chiefs of both the retailers and the manufacturers who are driving much of that change.
Even while it was engaged in its four-year struggle with Tesco, Levi Strauss, like many food and non-food manufacturers, had come to see that there was little point in trying to swim against such a powerful current. The San Francisco-based jeans maker, with Philip Marineau, a former PepsiCo and Quaker Oats executive, installed as a "turnaround CEO" in 1999, had already begun devising a strategy to sell a cheaper range of jeans through discount food and general retailers, starting with Wal-Mart in the US last year. "We realised there was a potentially valuable market out there. And we realised that, in Europe, it was the big retailers that would set the prices; we were not going to set the prices," says Cedric Jungpeter, Levi's spokesman in Europe.
Levi's also realised that this would mean a change in its manufacturing strategy. It had to cut its world-wide workforce by a fifth, close plants in western Europe (Belgium, France and Scotland) and North America (the last plants in the US and Canada were shut earlier this year), and contract out production to places such as Turkey, Hungary, Poland, Mexico and low-cost Asian countries. It is still reckoning the cost of the restructuring, which is already running into the hundreds of millions of dollars.
For Levi Strauss, selling through the discount retailers is imperative in order to move back into the black and pay off its massive debt, but it also risks eroding control over its brand, its customers and its pricing policy. In February, Apparel magazine wrote, "Everything that made Levi's into an American icon—quality, durability and originality—has been left out of the updated recipe. The Signature line is but a shell of the brand's former self—Levi's in name only."
The strategic consequences of this loss of brand control to the retailers have been a major concern of manufacturers since at least the mid-1990s, when they were first articulated by academics.
Pile Them High
Retailers are the flip-side of this coin—wresting control of consumer behaviour is a key objective. At Tesco, aggressive price competition has been at the core of that strategy, especially since Andrew Higginson took over as CFO in 1997 (under CEO Terry Leahy, who took the helm the same year). And the strategy has worked. Tesco's share price went from £1 in 1997 to £2.50 by last month. Pre-tax profit for the 53 weeks to February 29th 2004 was £1.7 billion on sales of £34 billion, up from £955m pre-tax on sales of £20 billion in 2000. It is now Europe's second largest food retailer, after Carrefour of France, and the world's fifth largest. To get to that position, Tesco first had to get over a few bumps.
"We had our 'road to Damascus' moment in the early 1990s, when the weakest players were considered to be Tesco and Asda [now part of the Wal-Mart empire]," Higginson recounts. "It was out of that adversity that the UK. strategy was born. That strategy was to say, 'Price is much more of a given in people's shopping pattern.' Twenty years ago, they were happy to spend more to shop in a nice environment, or to shop in a 'grotty' environment for a good price. In the early 1990s, they wanted it all—good prices, good services, good environment. And that coincided with the death of inflation." It also helped that leading competitors, such as Sainsbury's, "were less sensitive to that trend, whereas we were desperate."
Over the past decade, the price pressure in UK food retailing has been intense. The pressure came first from the encroachment of the German discounters, Aldi and Lidl, and then from Wal-Mart's acquisition of Asda. Following last year's takeover of Safeway by William Morrison, retail specialist Verdict Research predicts that food prices in the UK will fall by 0.1% in 2004, after a rise of just 0.8% last year. And price pressure is just as acute in Europe's other large markets, where sales growth has been weaker.
In this environment, the slim margins are maintained by putting relentless pressure on the cost base. At Tesco, "we have been absolutely tireless in taking out costs. We build stores for less than half what we did ten years ago [£120 a square foot, compared with £275 a square foot]," as Higginson explains. "We have constantly engineered and re-engineered our supply chain." This has also meant using its growing power to push its suppliers hard on price and payment terms.
On the Prowl
But wielding that power has its consequences. In February this year, the UK's Office of Fair Trading (OFT), the government's competition watchdog, said it would investigate whether supermarkets were complying with the Supermarket Code of Practice, introduced two years previously after the big retailers were found to be abusing their powerful positions. The OFT said a survey of suppliers found that "80% to 85% of respondents claim the code has failed to bring about any change in supermarkets' behaviour," but that most suppliers were afraid to make a formal complaint lest they be dumped by their powerful customers. One public complaint that was made in February came from a small family-run retailing chain in the north of England, Proudfoot, whose owner groused that Tesco was using "bully-boy tactics" and "predatory" pricing.
It is just such small local retailers and food suppliers that the 1996 Galland law in France is meant to protect. This law stipulates that the large retailers cannot sell goods at "below cost," as they can in Britain (as long as it's not deemed to be predatory). But the French law has not worked out exactly as intended. "In France, they cannot cut prices as they want to so they come up with 'creative' schemes," explains Gustavo Trompiz, editor and head of research at Paris-based CIES—The Food Business Forum, an industry association for food retailers and suppliers. For consumers, these often take the form of complicated voucher schemes with rewards that effectively reduce prices. For suppliers, it means negotiating cooperation commerciale terms—that is, a list of off-invoice charges to the supplier, such as payments to the retailers to get in their catalogue, for shelf space and so on. And these are ruthlessly used to squeeze suppliers.
"We fix tariffs, or list prices. After that it is a matter of negotiating the margin with the retailer," says the finance director of a mid-sized French food supplier, who did not want to be named. "If you are the number-two [brand] you get beaten up. If you are the number-three, you can expect to not make any money at all if you want to keep the volume. And you need the volume to cover costs when the customer has 20% of the market."
The challenge for those trying to raise the alarm about the growing power of the retailers is that it is hard to drum up public outrage over continually declining grocery prices. But Paul Dobson, professor of competition economics at Britain's Loughborough University, who wrote "Buyer Power in Food Retailing" for the European Commission in 1999 and has carried out similar research for the OECD, says a distinction has to be made between the short and long-term effects of the price pressure. "Consumers benefit from price pressure. The problem comes if suppliers end up pricing at variable cost without taking the total cost into account. You price at the margin rather than average costs, never covering fixed costs. This leads to under-investing and could lead suppliers to try to get around contract terms by not meeting quality aspects." The most worrying aspect of this has been the food scares of recent years, Dobson adds.
Changing the Game
Suppliers of all sizes have been affected by the trend. NestlÉ, the world's largest food maker with sales of SFr88 billion (€59 billion), has pursued a "wherever, whenever, however" distribution strategy over the last few years, specifically designed to find alternative distribution channels to the food retailers for products such as its pet food, ice cream and bottled water. The sharp cuts in the number of product lines by NestlÉ, Unilever, Proctor & Gamble (P&G) and other big consumer goods makers is partly a reflection of their reduced brand power.
"The manufacturers have circled their wagons around some big brands," explains David Aaker, professor of marketing at Haas Business School at the University of California in Berkeley and vice chairman of Prophet, a brand consultancy. "NestlÉ has coalesced around 12 brands and P&G credits its whole turnaround on focusing on just a few brands." Forcing the issue in Europe was "the ability of the stores there to build strong brands—and brands that go beyond efficiency and value. Retailers in Europe have been much better at building brands. In America, they've been absorbed in logistics, promotional kickbacks, store management. Manufacturers in America thank their lucky stars that that is the case."
This brand strength has extended to the growth of "own label" products in Europe, led by Britain where it accounts for about 40% of food sales. And it is growing rapidly in Europe, especially in standardised product lines.
Take cheese. Fromageries Bel, the €1.7 billion Paris-based cheese-maker has some of the most recognised brands in France and elsewhere, including La Vache qui Rit (Laughing Cow), Babybel, Port Salut and Leerdammer. But as CFO Susheel Surpal says, "The issue for us is that we're getting squeezed, squeezed and squeezed." The company has seen sales flatten over the last several years and it has struggled to keep operating profit and Ebitda from declining.
"We need to spend more and more all the time to support the brands. This is partly related to the growth of 'own brands' and the 'hard discounters'," says Surpal. "We need to increase spending to maximise our differentiation. In the last two years, we have increased pure advertising spending by 10%—above that when you include promotions. That's well above sales growth."
There are signs of change in France. Finance Minister Nicolas Sarkozy said in May that retail price laws will be reviewed this summer. That may make price competition more straightforward, but is unlikely to make it less relentless. One indication of the pressure French retailers put on suppliers is days payables outstanding (DPO). According to REL Consultancy Group, Carrefour had an average DPO last year of over 70 days, compared with a European average of 45 days. Suppliers of weaker brands or generic goods can expect to wait up to 130 days for payment from Carrefour.
Another indication of food retailers' power is that many of the largest—Tesco, Carrefour and Germany's Metro—are consistently in the top ten in the annual CFO Europe-REL working capital survey. Where they can, food manufacturers and ingredient suppliers pass this pressure for better credit and delivery terms down the chain to their own suppliers.
That's been the case at Danisco, a DKr17 billion (€2.3 billion) Danish food ingredients maker. "The general price pressure means that the whole agenda in the industry has changed," says CFO SØren Bjerre-Nielsen. He adds that working capital management at Danisco has been getting tougher, not least because of the growing requests from the companies that it supplies to extend credit lines.
Danisco, in turn, pressures its suppliers. One of its main products is pectin, which is used to thicken jellies, jams and confectionery and is derived from fruit peel. "Our customers are consolidating," explains Hans Henrik Hjorth, president of Danisco Textural Ingredients, which makes pectin. "Our customer base is becoming smaller and smaller, but the customers are bigger and bigger. And the way they can afford to do that is through synergies and their buying power. And the only way we can compensate for that is to focus on our costs." That has meant moving pectin production from higher-cost European plants in Denmark to Mexico, where production was increased by 25% this year, and Argentina. And the price pressure is passed on to the local citrus growers there.
The complaints of buyer power may be a relatively recent phenomenon, but retailers and their suppliers have always had an uneasy relationship. Back when he founded his first store in London in 1919, Jack Cohen (motto: "Pile them high, sell them cheap") chose the name Tesco to brand his new line of tea. The name was derived from the name of the tea supplier, TE Stockwell, and Cohen to reflect their partnership. Needless to say, the tea supplier has long since faded away.